“I don’t think the model makes that prediction, though. If you have a money demand shock that the monetary authority does not respond to by adequate monetary expansion, then the money supply could be going up while you see low output, low interest rates and low inflation, i.e the price effect is present in the model. Of course, they would still be higher than they would be in the counterfactual case where the monetary authority doesn’t respond at all to the shock.”

To avoid this problem I try to use event studies, wherever possible. Thus I focus on

the market response to unexpected monetary policy announcements. One market of interest is TIPS spreads. So if a monetary shock is contractionary, then TIPS spreads should decline on the news. Ditto for the price of foreign exchange.

The empirical evidence of interest looks at events that are clearly some sort of monetary policy surprise, and then looks at co-movements of interest rates, exchange rates, inflation expectations, etc.

]]>“I think it’s a mistake to focus too much on these sort of models, especially IS/LM, or indeed any New Keynesian model.”

I would draw a sharp distinction between those models. Krugman is wrong when he says that you can think in terms of IS-LM and use a Woodford style NK model to “make that intuition precise”. They are very different animals. That said, I agree neither of these models should be taken too seriously.

“I prefer to start from empirical data. We observe that some expansionary monetary shocks raise nominal rates and other expansionary monetary shocks reduce nominal rates (in the short run.) So right off the bat we know that any models that predicts rates always move in one direction after monetary shocks is wrong.”

I don’t think the model makes that prediction, though. If you have a money demand shock that the monetary authority does not respond to by adequate monetary expansion, then the money supply could be going up while you see low output, low interest rates and low inflation, i.e the price effect is present in the model. Of course, they would still be higher than they would be in the counterfactual case where the monetary authority doesn’t respond at all to the shock.

When I talk about the model being neo-Fisherian, I am referring to a scenario in which there’s no money demand shock, but the monetary authority permanently raises the money supply. It’s hard to glean from empirical data what happens if the monetary authority does this, because in the real world the monetary authority will often be responding (sometimes insufficiently) to money demand shocks anyway. There’s no central bank which will say “we raised our total liabilities by %100 forever so Ege could see what happens if we do that”.

“The next step is to figure out why some monetary shocks have one effect and other monetary shocks have the opposite effect. We know that if you evaluate monetary shocks in terms of the “price effect” it is easy to explain why rates rise on some cases and fall in others, but if you evaluate monetary policy in terms of the interest rate effect it gets a lot more confusing, as there are lots of indeterminacy problems.”

I agree, but this doesn’t change much, because I’m not suggesting we think of monetary policy using interest rates. I’m simply pointing out that monetary policy does have an impact on interest rates. To me, neo-Fisherism is the claim that easy money policies which are expected to be sustained create enough expectations of inflation so that real interest rates fall while nominal interest rates rise when the policy is announced. It’s not the claim that “high interest rates raise inflation”.

I don’t want to look at empirical data crudely to test this claim, because if you throw expectations about future policy into the mix, then it becomes increasingly difficult to entangle the effects of current policy vs. market expectations of future policy. If the market expects future policy to be sufficiently tight, then that can offset any inflationary effects of present easy money policies, and leave us with low nominal interest rates and seemingly easy money.

“BTW, since MV=PY is a tautology, any true model must be able to be explained in MV=PY terms.”

Sure, but what I mean by “the model has MV = PY in it” is that V is an increasing function of the interest rate spread between bonds and money, which is far from a tautology.

]]>“Yes, that’s precisely their claim: they are saying that easy money leads to higher nominal interest rates, in the short run and in the long run.”

Sorry, I misread your earlier comment. My mistake.

I think it’s a mistake to focus too much on these sort of models, especially IS/LM, or indeed any New Keynesian model. You can write down models to get any result you want. I prefer to start from empirical data. We observe that some expansionary monetary shocks raise nominal rates and other expansionary monetary shocks reduce nominal rates (in the short run.) So right off the bat we know that any models that predicts rates always move in one direction after monetary shocks is wrong.

The next step is to figure out why some monetary shocks have one effect and other monetary shocks have the opposite effect. We know that if you evaluate monetary shocks in terms of the “price effect” it is easy to explain why rates rise on some cases and fall in others, but if you evaluate monetary policy in terms of the interest rate effect it gets a lot more confusing, as there are lots of indeterminacy problems.

BTW, since MV=PY is a tautology, any true model must be able to be explained in MV=PY terms.

]]>The usual way monetarists tend to think about monetary expansion is directly from MV = PY: with sticky prices, some of high M leads to high Y on impact, and some of it is “absorbed” by lower V, i.e lower nominal interest rates. The MV = PY relation is there in the model above, but instead it predicts expanding the money supply actually increases V (because it generates expected inflation). This is essentially why the model is neo-Fisherian.

]]>Yes, that’s precisely their claim: they are saying that easy money leads to higher nominal interest rates, in the short run and in the long run. Cochrane works with a model with money in the utility function in a paper, and he finds with some specification of parameters that to produce an initial decline in nominal interest rates from easy money you need a real money supply that’s about four times annual real GDP. He dismisses this scenario as unrealistic, though of course his model is not any kind of serious econometric work.

If you’re not a fan of the FTPL, then consider some model where you have the usual MV = PY where V is an increasing function of the interest rate spread between money and what you can get elsewhere in the economy. If you add this to a New Keynesian perfect foresight framework, log-linearize and mix, you get a three-dimensional system with one negative eigenvalue in (nominal interest rate, output gap, inflation) space, and the saddle path is in the (+, +, +) direction. Of course, in this model we no longer have the FTPL concerns, so the monetary authority can increase the money supply to deal with a money demand shock without any constraints, which is the optimal policy for dealing with these transient shocks in the model.

On the other hand, the model is still neo-Fisherian. It follows from the direction of the saddle path that inflation and nominal interest rates *in the broader economy* (not IOER) always rise and fall together, so an unexpected and permanent expansion of the money supply to deal with a money demand shock produces high NGDP and high nominal interest rates at the same time. Raising the IOER without raising money growth, however, only leads to low inflation and low nominal interest rates. (In the FTPL model, it was impossible for the central bank to raise IOER and not raise government liability growth, so we didn’t have this problem.) “Raise interest rates to raise inflation” doesn’t work if you’re raising the IOER and not using easy money policy to generate expectations of inflation.

The crucial thing leading to these results is really the intertemporal substitution relation, i.e the IS curve looking like dx/dt = k(r – R) instead of x = k(R – r) where x is the output gap, k is some constant, r is the real interest rate and R is the natural interest rate. In my experience, the neo-Fisherian models are precisely the ones with “dx/dt” and not “x” in the IS curve. The FTPL is not essential to producing most of the neo-Fisherian results, they come out of MV = PY just as readily.

]]>But I agree that Williamson is not doing a good job explaining the theory in a way that will convert skeptics.

If they would spend more time talking about cases like Switzerland circa January 2015, they’d have more success.

Ege, You said:

“Neo-Fisherian models don’t have the property that tight money policy leads to high inflation, which I think is what many people are inferring by looking at the claims being made by Williamson and Cochrane.”

No, that’s missing the point. They don’t claim that tight money causes inflation, they claim that higher interest rates are EASY MONEY. At least that’s been my assumption. Do you think they’d call hyperinflation “tight money”

I’m not a fan of the FTPL, which I don’t think applies to countries such as the US.

dtoh, I don’t agree. Any excessively contractionary or expansionary policy is a sign of incompetence. A neutral stance means hitting your target.

]]>I think we were talking about evaluating the stance of Fed policy, i.e. whether it’expansive or contractionary.

You said,

“I don’t think asset purchases are a good indicator. I prefer the price of NGDP futures contracts.”

NGDP futures contracts would tell you whether policy is on target but it would not necessarily tell you the stance of policy. If the Fed were perfectly competent, you could tell policy was contractionary if and whenever futures were above target and vice versa. But if the Fed were not perfectly competent, futures would not necessarily tell you anything about stance. You could be under target and the Fed could still be pursuing contractionary policy.

So in sum i) futures are a good indicator or whether or not policy is on target, and ii) changes in assets purchase from (or money injected into) the non-banking sector are a good indicator of stance.

]]>I agree that thinking of monetary policy in terms of interest rates alone is misleading, for essentially the same reasons. Neo-Fisherian models don’t have the property that tight money policy leads to high inflation, which I think is what many people are inferring by looking at the claims being made by Williamson and Cochrane. For instance, Cochrane works with the frictionless fiscal theory equation, in which case increasing IOER increases the growth of nominal government liabilities outstanding, so it’s an “easy money” policy. Indeed, adding some kind of nominal anchor (like a cash-in-advance constraint or the government debt valuation equation) to these models resolves the indeterminacy problems.

Neo-Fisherism has some other aspects, though. For instance, if we’re in frictionless FTPL land, then it says that if the monetary authority is fixing short term nominal interest rates, they can go out and buy all the mortgage-backed securities they want and it may have no effect on inflation or NGDP. The usual comparison with Zimbabwe is misleading because Zimbabwe had an insolvent government. The most reliable way that the monetary authority can ensure higher inflation is to raise IOER in this case, for obvious reasons: high IOER means high money growth. If the monetary authority instead fixes IOER at 50 bps and starts buying private assets and expanding total government liabilities, then it has to convince investors that the expansion is permanent, and this is very tricky because the expansion can be undone by a fiscal policy change as much as it can be by a monetary policy change. (How reliable are the Treasury’s five year deficit forecasts?)

In short, if we want to keep the monetary authority and the fiscal authority as separate entities, then what the monetary authority with an IOER or an ON-RRP facility should do is to raise these policy rates sharply in a slump. This way, the monetary authority ensures high money (or, in this case, government liability) growth, which raises nominal incomes and cuts the recession short. If the monetary authority tries lowering rates and hits the ZLB, then they will be following tight money policy even if they don’t realize it.

]]>My conclusion is they are crazy. I am hearing and reading nothing that redeems them, but happy to be corrected.

]]>